Stockton, Calif. Joins Growing Number of Bankrupt U.S. Cities

Stockton, Calif., staggering under mountains of debt, much of it tied to public employee pensions and benefits, was poised Wednesday to become the largest U.S. city ever to file for bankruptcy.

Once a rare occurrence as cities and towns sought just about any other option to avoid the stigma and costs of bankruptcy, Chapter 9 filings are becoming more common, experts say. Local governments across the U.S. are struggling to fulfill fiscal obligations promised during healthier economic times.

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Since 1937, when Congress added Chapter 9 to the bankruptcy code to allow municipalities to seek protection against creditors, about 640 government entities have filed, according to James Spiotto, a Chicago-based attorney who tracks municipal bankruptcies.

The numbers have risen sharply in the past two decades, especially since the financial crisis of 2008 following the collapse of the U.S. housing market. In 2011, a total of 13 filings occurred, or more than double the six filed in 2010.

Stockton, an agricultural and port center with a population of about 300,000 located 85 miles east of San Francisco at the northern edge of California’s Central Valley, is the seventh government entity to file for bankruptcy protection this year.

“These have been viewed in the past as aberrations, but maybe this will be a wakeup call,” said James Spiotto.

Spiotto warned that many public employee contracts will have to be re-negotiated because local governments simply don’t have the money to cover generous pension and benefit packages awarded to employees in past years.

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Public employee unions in the past have been reluctant to re-negotiate and allow for the scaling back of pensions and benefits.

“We need a capacity for growth and change in that area,” he said. “If you don’t have the funds to pay for something you can’t pay. That’s just a reality.”

Stockton Bankruptcy a “Template” for Other California Municipalities

In an effort to close a $26 million budget gap, Stockton’s city council members approved a budget plan Tuesday night that assumes the city will file for Chapter 9 bankruptcy before July 1.

"The path that Stockton charts over the next several months could become a template for some other cities and local governments who will increasingly fall under similar pressures. The current public salary and benefit structures are not sustainable and something will eventually have to give."

Michael Shires, Pepperdine University’s School of Public Policy

In a statement published on the city’s Web site, Stockton announced that the $155 million budget approved by the council “is essentially the budget and the plan that is followed for the day-to-day operations of the City while in bankruptcy.” The plan, according to the city’s statement, “identifies what expenditures will be reduced or suspended.” Stockton will continue to pay its employees, vendors and service providers.

The plan approved Tuesday is a blueprint for restructuring employee pay and benefits in an effort to deal with Stockton’s “unsustainable long-term debt,” the statement reads.

Reuters reported that Stockton’s bankruptcy budget would cut employee payrolls and retiree benefits by $11.2 million. The city would also save about $7 million by cutting retiree medical benefits for one year and then phasing them out altogether.

Stockton is typical of many municipalities suffering in the aftermath of the collapse of the U.S. housing market. After property values soared in the mid-2000 on hopes that Stockton would become a bedroom community of San Francisco, housing prices have fallen dramatically in the city, taking tax revenues with them.

As a result, Stockton, like other cities, has found itself unable to cover generous pension and benefit costs promised to public employees during the flush years ahead of the financial crisis. The situation in Stockton closely mirrors that of Vallejo, Calif., which filed for bankruptcy in 2008.

“Stockton is in a mess because they are spending too much for the services their government is producing at a time when their revenues have collapsed. And they see Chapter 9 as their only possible path to getting out of the overly optimistic and generous commitments that they have made,” said Michael Shires, an associate professor at Pepperdine University’s School of Public Policy.

Shires said other debt-addled California municipalities are likely to follow in Stockton’s path.

“To me, the bigger story is how Stockton has avoided it this long,” said Shires. “California cities, counties and agencies have a long history of very generous benefits for their public employees -- benefits that are unrivaled in any private sector setting. The old argument that these benefits were necessary to attract good people to public employment because of its low salaries does not fly in today’s environment where public sector jobs are among the highest paying in many areas. This generosity, coupled with a political process where public sector employee unions are often one of the main campaign funding sources for the elected officials who will in turn negotiate their contracts, has led to a public service cost structure that is higher than any other state.”

Shires added, “The current state of affairs in Stockton, while exacerbated by the ‘perfect storm’ of the housing bubble collapse, an unsustainable surge in revenues and bad fiscal choices, is not that unique in California. In fact, the path that Stockton charts over the next several months could become a template for some other cities and local governments who will increasingly fall under similar pressures. The current public salary and benefit structures are not sustainable and something will eventually have to give.”

“Chapter 9 is a process not a solution,” said Spiotta. “You’ve got to have a recovery program that solves the problems that got you to Chapter 9.”

For instance, bankruptcy protection won’t cure the economic problems that have forced record foreclosures in Stockton and pushed unemployment to about 15%. Nor will it cure public safety issues such as rising inner-city violence that scare off businesses and investment, taking away much-needed jobs.

“Bankruptcy doesn’t change your economy,” Spiotta added. “It may reduce the amount of debt you have but that’s all it does. You need to make sure going forward that the costs you do have -- labor, public safety, services -- are sustainable and affordable.”

In an effort to avoid bankruptcy in recent years, Stockton has slashed more than $90 million from its budget, laying off city workers including a quarter of its police force.

Stockton has already defaulted on about $2 million in debt since February. Indeed, a newly constructed building set to become Stockton’s city hall was seized by creditors for non-payment of debts.

Credit ratings firms Moody's Investors Service and Standard & Poor's Ratings Services have cut their credit ratings on Stockton, which means it will be more expensive for the city to borrow in the future.

Spiotta said higher borrowing costs are another significant danger posed to municipalities by a bankruptcy filing, a situation that’s not easily or quickly resolved and one that could lead to a potential “death spiral” of slashed services and fleeing businesses.